People frequently use promissory notes when providing loans either for investment purposes or just to help out friends and family members who cannot obtain traditional financing. It is important to realize that there are income tax consequences for both lenders and borrowers any time interest is earned, paid or forgiven on a promissory note.
Principal, Interest and Basis
The most important components of a promissory note that you must consider for tax purposes are the note's principal, interest and tax basis. A note's principal is the amount of money loaned, and the note's interest is the income earned by the lender for loaning the money. Every investment has a basis, which you can think of as the original purchase price and costs incurred to acquire the investment. You are not taxed on the value of your basis in the investment. The tax basis of a loan is the amount of money loaned -- the principal.
General Tax Implications for the Lender
Generally, any income you generate from a promissory note is taxable income and must be reported. The income generated is simply the interest you earned on the note for the tax year in question. If you lent the money personally rather than through your business, report the income on your personal income tax return. If the income from interest is more $1,500, you must report the interest on Schedule B of Form 1040 or 1040A.
General Tax Implications for the Borrower
Tax implications for the borrower largely depend on whether the loan is used for personal purposes or business purposes. If the loan is for personal purposes, the interest payments are generally not deductible unless the loan qualifies as a home loan under IRS regulations. On the other hand, if the loan is for a valid business purpose, you may be able to deduct interest payments as an ordinary and necessary business expense as permitted under IRS regulations.
Loan Forgiveness, Below-Market Loans and Forgone Interest
No good deed goes unpunished, and tax law is no different. Generally speaking, if you forgive a loan, the amount forgiven is treated as income, and the borrower must report it on her tax return. If you provide a loan at an interest rate below a rate set by the IRS, you may be subject to rules regarding below-market loans, and you may have to treat forgone interest as income. These rules are fairly complex and require careful study or the assistance of a tax professional.
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